Moody’s warns United States of rating cut as fiscal cliff looms

Everybody knows that if we don’t get our house in order, we’re in trouble

Moody’s Investors Service said it may join Standard & Poor’s in downgrading the U.S.’s credit rating unless Congress reduces the percentage of debt-to-GDP during budget negotiations next year.

The U.S. economy will probably tip into recession next year if lawmakers and President Barack Obama can’t break an impasse over the federal budget and if the George W. Bush-era tax cuts expire in what’s become known as the “fiscal cliff,” according to a report by the nonpartisan Congressional Budget Office published on Aug. 22. The rating would likely be cut to Aa1 from Aaa if an agreement isn’t reached, Moody’s said in a statement.

Moody’s put the rating under review with a negative outlook in August 2011, when the U.S. pushed back a decision on spending and raised its so-called the debt ceiling after months of political wrangling. S&P cut its rating to AA+ that month, blaming the nation’s political process. Investors ignored the reduction and Treasuries rallied, with the yield on the benchmark 10-year note since declining to record lows and the S&P downgrade drawing the ire of investors such as Warren Buffett, the biggest shareholder of Moody’s, who said after the S&P decision that U.S. should be “quadruple-A.”

“At some point, we might see the market demand a higher yield premium to own Treasuries, but I don’t think that’s the case now as this is just a shot across the bow,” said Jack McIntyre, a money manager in Philadelphia at Brandywine Global Investment, which oversees US$30-billion of debt. “It’s hard to find a bond market that has the depth of liquidity that Treasuries do.”

Deficit Watch

McIntyre said his firm has reduced its Treasury holdings to lock in recent gains. U.S. government debt has returned 6.4% since the S&P downgrade and gained 9.8% in 2011, the most since 2008, according to Bank of America Merrill Lynch index data.

The Obama administration’s February budget that was updated in August would result in a debt-to-GDP ratio of 75% in 2022, New York-based Moody’s said.

“We will wait and see what they do in 2013, whether or not they come up with a specific proposal,” Steven Hess, senior vice president at Moody’s in New York, said Tuesday in a telephone interview. “If there is no result and they delay doing anything serious on deficit reduction, it’s likely that in 2013 we would move the rating down.”

The budget deficit will reach US$1.1 trillion this year, according to the CBO. That would be down from last year’s US$1.3 trillion, in part because tax revenue has risen by almost 6% and spending is down by about 1% this year.

Coin Flip

The U.S.’s Aaa rating with negative outlook would only be extended beyond 2013 if a “‘fiscal cliff’ actually materialized,” Moody’s said Tuesday in the statement. “Moody’s would then need evidence that the economy could rebound from the shock before it would consider returning to a stable outlook.”

For investors and policy makers, predicting the consequences of a rating change by S&P or Moody’s — the dominant issuers of debt scores — may be little different from flipping a coin.

Almost half the time, government bond yields fall when a rating action suggests they should climb, or they increase even as a change signals a decline, according to data compiled in June by Bloomberg on 314 upgrades, downgrades and outlook changes going back as far as 38 years. The rates moved in the opposite direction 47% of the time for Moody’s and for S&P. The data measured yields after a month relative to U.S. Treasury debt, the global benchmark.

Yields Rise

“Everybody knows that if we don’t get our house in order, we’re in trouble,” said Thomas Roth, senior Treasury trader in New York at Mitsubishi UFJ Securities USA Inc. “If you get downgraded twice, you’re certainly not going to lend to that government at a lower rate.”

The 10-year yield rose four basis points, or 0.04%age point, to 1.69% at 10:56 a.m. in New York, according to Bloomberg Bond Trader prices. The price of the 1.625% note due in August 2022 fell 10/32, or $3.13 per $1,000 face amount, to 99 12/32. The yield fell to a record low of 1.379% on July 25.

The U.S. dollar declined to its lowest level in almost four months versus the euro, weakening 0.7% to $1.2847. The dollar has rallied 11% against the euro since the S&P downgrade in August 2011.

Fitch Ratings assigns the U.S. its top AAA ranking with a negative outlook.